Apple: Cheaper iPhones Tricky, Says UBS; iOS 7 May Restore Innovation

By

Tiernan Ray

July 2, 2013 11:13 a.m. ET

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Shares of Apple (AAPL) today are up $9.74, or 2.4%, at $418.95, as UBS's Steve Milunovich reiterates a Buy rating on the shares, and a $500 price target, writing that the company must respond to a maturing smartphone market by perhaps taking share, going for value shoppers, or just branching out into other categories.

The worldwide smartphone market is nearing the upper bound of what household income can support for top-tier smartphones, writes Milunovich, making the smartphone market fairly mature as a market:

Smartphones now account for the vast majority of volumes in many markets. In the US, we estimate smartphones constitute 90% of total post-paid handset sales (75% including pre-paid), and at the major operators in Western Europe, Japan, and Korea our estimate is 70-80%. Globally, we estimate smartphones reached more than 50% of total shipments in 4Q/12. Our affordability work using household income distribution shows an upper limit of high-end penetration of about 60% in developed markets and 25% globally. Replacement sales were about 65% of total sales in the US in 2012, another sign of maturity.

Thus, Apple faces the "Innovator's Dilemma," he writes, citing the work of Clay Christensen:

A maturing market is problematic for Apple, not only in terms of available growth but potentially for its integrated strategy. Recall the Christensen model that new technologies typically require vendors to provide integrated products that compete on performance. As the technology improves and meets most user needs, more open, good enough approaches tend to do well as the basis of competition shifts to time-to-market. Apple has enjoyed huge success by employing its competencies in hardware, software, and services to provide arguably the best phone experience. But it this still a differentiator?

Milunovich thinks going "down market" will be challenging:

If the high end is slowing, the obvious answer is to head to lower price points. Although analysts are anxious for Apple to broaden the iPhone line, we think the company has to be careful. Its brand cannot afford significant quality dilution— short-term gain could result in long-term pain. Management is very aware of the risk as reflected by Tim Cook's comment that Apple is about making the best products rather than the most. If Apple wanted to go really low end, the right way to do it would be to set up a separate brand and perhaps even a wholly- owned subsidiary. But we don't expect Apple to veer from its current strategy. The expected "low-end" iPhone probably won't be priced below $350-400. Even at that level the gross margin could be near 30% and become an example of the company's occasional willingness to accept lower margins to penetrate a market, as CFO Peter Oppenheimer said recently. In Figure 9 we suggest that the $300-500 price range only will be 10% of the market in 2014. That still means millions of incremental buyers in emerging markets but will not radically change Apple's market share […] We expect China Wireless to ship approximately the same number of Coolpad smartphones as Nokia (NOK), Blackberry (BBRY), and HTC (2498TW) in 2013 but recognize revenue that is 3-4x smaller for Coolpad due to a lower ASP of $90 vs. $300. We expect that a couple Chinese vendors will break out globally; given their scale, Huawei/Lenovo are most likely.

Milunovich thinks the company can change investor sentiment to again claim the mantle of innovation. He cites writings of Daniel Dilger, Ben Thompson, and Marco Ament lauding the advantages to the company of the forthcoming iOS 7:

Blogger Daniel Dilger questioned whether the view that Apple is a closed system and therefore in trouble is correct. "Rather than serving some grandiose 'open' purpose, the primary thing Windows and Android have done is to hide incompetence, reward failure, and transfer intellectual property from an investor to a pool of manufacturers with myopic vision and waning creativity." Similarly, Marco Ament pointed out that "Copying iOS 7 is going to be a big problem for cheap hardware. iOS 7's appearance and dynamics require a powerful GPU and advanced, finely tuned, fully hardware-accelerated graphics and animation APIs. While high-end Android phones have mostly caught up in GPU performance, and recent Android versions have improved UI acceleration, most Android devices sold are neither high-end nor up-to-date." Finally, Ben Thompson of Stratechery argued that Apple's focus on end user experience shields it from disruption because it is impossible for the experience to be too good. In other words, "overshoot" in Christensen's model is not possible though we would think there is still a risk of "good enough" pressuring Apple pricing.

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